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New SEC Limit Up/Down Proposal Would Have Made Flash Crash Worse

Bellwether stocks halted and frozen near the bottom! See charts below.

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We have read the SEC Limit Up/Limit Down Plan to Address Extraordinary Market Volatility (LULD, or the plan). We have also read through the comments submitted to the SEC by knowledgeable professionals in the industry, and we agree with nearly all of the concerns presented. There are a few worrisome problems that are not presently addressed in the commentary nor the plan itself. These troubling concerns were not immediately apparent; they only presented themselves after we undertook the effort to simulate what would have happened on May 6th, 2010 if the plan was in effect. That was the day of the flash crash, which is the whole reason this plan is being proposed. We'll briefly mention the most troubling concerns we found, so that we can keep this paper short.

No software developer with any sense was part of this process.

The first thing we discovered when coding the LULD rules, is that no software developer with any sense was part of this process. This we are sure of. Let us explain. There is a need to have reliable prices for calculating trading bands, because triggering false trading halts could be far worse than not having a limit at all. The plan tries to achieve stable prices by averaging all trades over the last 5 minutes. This method is extremely processor and memory intensive, because for each symbol, the software needs to buffer anywhere from 1 to 100,000 or more trades. Worse, stocks that hardly trade will have just a few trades (or none) in the last 5 minutes: so the very stocks that need a price stabilization method will get no benefit from this approach! The best way to ensure stable prices with minimal processor and memory overhead is to use an exponential moving average.

The second glaring problem is one of robustness, or rather a lack of robustness. Readers should know that trades and quotes are processed by separate systems, which are often out of sync by hundreds of milliseconds during normal trading, and many times that amount during active (not crazy) trading. However, the plan assumes, at its very core, that these two very different systems will magically always be in sync. And this is a plan designed to alleviate problems during times of severe market stress! Many competent software engineers have been fired on the spot for less. The solution here, is to pick one of the two systems (hint: use quotes) and avoid any dependencies.

The third, and perhaps most important problem, is that the plan persists an ambiguity of the definition of the NBBO in Reg NMS and how the NBBO is (not) used to route orders to protected quotations. The ambiguity arises because the language of Reg NMS assumes that information is transmitted instantly: at the time when Reg NMS was written, the speed of light was so fast it was, practically speaking, instant. This, coupled with intense competition to be the fastest at all costs, led to exchanges using their own internal calculation of the best bid or offer as a substitute for the real NBBO for order routing and trade through protection.

We think it would be prudent for the SEC to clearly document how an investor's order is routed through the system at each step in the process, in detail, with particular attention paid to the step when the NBBO is taken into account.

So it would seem to us that exchanges either have to abandon and rewrite the order routing layer to adopt the plan as it is written (not very likely), or they intend to apply the definition of the NBBO to mean the one that each exchange calculates internally and ignore the NBBO as defined in Reg NMS. In light of this continued ambiguity, we think it would be prudent for the SEC to clearly document how an investor's order is routed through the system at each step in the process, in detail, with particular attention paid to the step when the NBBO is taken into account.

Finally, the delays in quote and trade dissemination from the SIPs are common and significant enough that it will lead to new forms of latency arbitrage when stocks approach their limit bands. Latency arbitrage always favors the trader with the fastest speed, to the detriment of everyone else.

The SEC has proposed many band-aid fixes since May 6, 2010 in an effort to make investors feel confident again about the equity market. The sad truth though is that none of their proposals so far will prevent another flash crash. Worse, some proposals, such as this one, will likely make things even worse.

The Simulation

Since it is impossible to simulate what would have happened after a trading band is hit, we decided to stop the calculations for a stock once it hits a band. We show the time and price where a stock hits a band, and where the prices actually traded, since there was no pause on that day. It is up to you, the reader, to imagine the impact from halting trading in the stock at the price and time indicated.

On the day of the flash crash, 350 symbols would have hit the price bands as defined by the plan. Of these, only 3 symbols hit their price bands before trade and quote systems became overloaded and severely stressed. 304 symbols hit bands after the emini began its 5 second halt.

One saving grace of the flash crash was that it happened so fast, a lot of people didn't have time to react.

It is very troubling to see so many large capitalization, widely-held stocks triggering a pause or halt near their very lows. We wonder how this would have impacted index calculations, futures prices, options, ETFs and other equivalent assets. We wonder how much these halts would have prolonged the event. One saving grace of the flash crash was that it happened so fast, a lot of people didn't have time to react. Many people weren't even aware of the crash, or its severity, until after it was over.

SPY Prices showing when the Limit Up/Down price bands hit. A red dot indicates when a stock hit its band.

We present below, the charts of a few large capitalization, widely-held stocks that hit their simulated trading bands using data from May 6, 2010. The circle shows the time and price where the stock would have triggered a pause or halt if the plan as it is written were in place on that day. All of these trigger points occur when liquidity was near its lowest point, so it was highly likely that trading halts of 5 minutes or more would have frozen all these stocks at the point indicated by the circle; allowing far more investors to experience the anxiety of the flash crash in real time.

If you are interested in viewing all 350 chart images, please send us an email.

DIS - Walt Disney Company

IBM - International Business Machines

AVP - Avon Products

DOW - Dow Chemical Company

TWX - Time Warner, Inc.

MRK - Merck & Company, Inc

ABT - Abbott Laboratories

ORCL - Oracle Corp

CSCO - Cisco Systems, Inc.

VXX - iPath S&P 500 VIX Short Term Fund

GE - General Electric Company

MU - Micron Technologyy

HPQ - Hewlett-Packard Company

IYR - iShares Dow Jones U.S. Real Estate

JDSU - JDS Uniphase Corporation


Publication Date: 08/02/2011

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